How to use passive losses and passive income generators as a tax strategy

Back in the 1980s, taxpayers with a high tax rate would invest into real estate and other similar investment vehicles and end up with large upfront losses, such as depreciation, that offset their other ordinary income. Many thought this type of sheltering maneuver was unfair, says Tony Constantine, tax partner at Ciuni & Panichi Inc.

To slow this tax sheltering down, Congress created a framework of rules and classifications of activities for passive and non-passive income. Taxpayers can now only can offset passive losses again passive income. And if there is no passive income, it carries forward.

“That’s where a passive income generator comes in because it can be a tough pill to swallow when you’ve got a $20,000 loss on your tax return that you cannot utilize,” Constantine says. “If you have passive activity losses carrying forward, you can invest in something and accelerate the use of the losses that would be available at some point in the future.”

Smart Business spoke with Constantine about pairing passive losses with passive income generators.

How do taxpayers acquire passive losses?

Passive losses are ordinary losses generated by a passive activity. A passive activity is a business that a taxpayer is not involved in such as a silent partner in a business or owning real estate. Just because an activity has a passive loss doesn’t mean it’s a bad investment. It could be a rental property that has significant depreciation in any one year, which generates a loss, but is still cash flowing.

There is a framework of rules governing whether a taxpayer is a passive investor. However, it’s not cut and dry when looking at multiple activities. If you’ve invested in, say, five different real estate properties, it goes property by property and there’s an aggregation election you can make, if you meet certain hour requirements.

It’s also important to note that looking at financial statements or refinancing a property are considered investor activities. They don’t count as spending time on an activity for non-passive purposes.

How does someone know if they have passive losses on their tax return?

If you cannot remember if you’re carrying passive losses forward, check to see if Form 8582 is part of your tax return package. This form details out all passive loss carryforwards.

If your underutilized losses are building up, you can look at certain investments that might generate some income of a passive nature to offset that.

What investments can provide passive income generators?

A passive income generator may not fit everybody and you never want to let the tax tail wag the dog, but it’s beneficial to consider the investment tools that are out there to set your affairs up in the most tax-efficient manner.

Passive income generators can be an investment that’s marketed as a passive income generator, such as real estate or private equity funds that are structured in such a way that they’re going to throw off income. They may be more mature properties that don’t have much depreciation and little interest deduction, so they’re in the cash flow stage. You invest in a property that’s going to appreciate in value and throw off some income and corresponding cash, but you shelter it with your passive losses.

You never want to make an investment just to offset passive losses, because every investment has its risk. If something is supposed to be a passive income generator, it could be a loss if something goes wrong. But if you’ve looked the risks and you want to make an investment, making one in something that is going to generate some passive income to offset your passive losses just makes sense. You’re going to save yourself tax on that, either that year or in future years by offsetting the two.

Insights Accounting is brought to you by Ciuni & Panichi Inc.

Recover your capital investment more quickly through cost segregation

If your company is planning to build, purchase or renovate a building, or has done so in the past several years, a cost segregation study could help boost your cash flow and save your company significant money, says Chris Bzinak, CPA, senior tax professional at Clark Schaefer Hackett.

Cost segregation studies separate personal property from structural components, putting personal property into depreciable categories, which allows taxpayers to depreciate property over much shorter periods of time as opposed to the standard 39-year (or 27.5-year residential) time frame. By taking these deductions sooner, property owners lower their current-year tax liability and free up more capital.

Smart Business spoke with Bzinak and Kathy Pugh, CPA, tax director, about how cost segregation studies can be a smart tax strategy.

How should property owners determine whether a cost segregation study will benefit them?

First, property owners should understand their tax situation up front. Is it advantageous to accelerate deductions now, rather than in the future?

The experts performing the study can discuss on a case-by-case basis whether the money owners invest will be worthwhile. Typically, a facility should have been placed in service within the last five years, and the cost of the building, remodel, expansion or build-out needs to be at least several hundred thousand dollars. Generally, a free feasibility study will show the amount of increased deductions and cash flow over the life of the building, which gives property owners the ROI and the net present value of their tax deferral.

What type of savings can property owners expect?

In general, 20 to 40 percent of the purchase can be reclassified as personal property and depreciated more quickly, usually in five-, seven- or 15-year increments. Flooring, signage, landscaping and parking lots are examples of components that can often be reclassified.

Tax law changes to expensing rules, however, have increased the benefit of cost segregation. Now, anything that falls under a 20-year depreciable life is eligible for bonus depreciation, which means property owners can take 100 percent of the cost in year one. Roofs, HVAC systems, fire alarm systems and security systems installed on existing commercial buildings also may be eligible for immediate expensing under Section 179.

Are there any risks to doing a cost segregation study?

Property owners should ensure those doing the cost segregation study are utilizing an IRS-approved method with documentation that can stand up to an audit. Rather than doing a full cost segregation study with a reputable firm, some property owners will come up with estimates without the proper analysis and site visit. If they use those generalities to adjust their tax return, they face the risk of an IRS audit without evidence to support their actions.

How should building owners prepare for the analysis? How will the study be conducted?

Once an owner decides to go forward with a study, the experts conducting the study will need to ask questions, look through the appropriate documents and do a site visit to take photos, measure and count different items in the facility. If a building is newly constructed or remodeled, it’s important to have the contractor’s payment applications and facility blueprints ready. An older building’s study can be based on a depreciation schedule and appraisal from the time of purchase.

A report that breaks down the reclassification will then be issued to the property owners, who can take that to their accountants and apply it to their taxes. Most likely, this will not require them to amend their tax return; the owners just file a Form 3115, which is an application for change in accounting method to adjust their deprecation.

Under today’s tax rules, virtually every taxpayer who owns, constructs, renovates or acquires a commercial (or residential) real estate facility stands to benefit from a cost segregation study. Is it time to see if you can recover your capital investment sooner?

Insights Accounting is brought to you by Clark Schaefer Hackett

If the idea of a ransomware attack doesn’t keep you up at night, it should

Ransomware is like New York City, says Shawn Richardson, principal of Cyber Services at Rea & Associates.

Ransomware is a type of malware designed to threaten to publish the victim’s data or block access to company data until a ransom is paid. The two main types are designed to encrypt or lock out information so data aren’t readable and the victim cannot gain access.

Locker ransomware locks the computer, server or device, and Crypto ransomware prevents access to files or sensitive data through encryption. Believe it or not, ransomware dates back to the late 1980s with the AIDS Trojan. It’s been evolving since. Just like how New York’s downtown buildings have constantly changed over the past 25 years, ransomware gets bigger, better and more modern as bad actors build upon past forms.

“It’s gotten sophisticated,” Richardson says. “The ransomware is injecting itself inside of applications such as email through phishing. Often, all it takes is clicking on an email to execute some malicious code. Then, it attaches to local information stores like customer databases or accounts payable.” 

The cybercriminal promises to restore the data if the victim pays a ransom — but there is no guarantee you’ll get your data back, even if you pay. In some instances, attackers ask for a little bit of money first to generate trust and then extort more funds.

Smart Business spoke with Richardson about the ransomware threat, which may loom larger than you think.

What are examples of ransomware attacks?

The most prevalent types of ransomware are CryptoWall, Locky and WannaCry. But as they get used, people take the code, make copies and improve it with higher levels of encryption. There are variants that are uncrackable, and federal authorities don’t have the ability to reverse engineer the modified versions of ransomware. 

In one case, ransomware was dropped into a company’s Microsoft Office 365. It locked down the user database. Then it elevated the account permissions to allow the attackers to exfiltrate information and sent emails to the organization’s bank. Fortunately, the federal authorities caught on to what was happening before funds were transferred.

In another instance, a services company with fewer than 50 employees was attacked. The ransomware hit the backups first, which were not properly segmented off from the existing networks, and then locked its customer database and service contracts. The business never recovered the data and ultimately had to go back to a backup that was incomplete and nearly a year old.

Do businesses need to actually be attacked to feel the effects of ransomware?

No. A business can run the risk and hope nothing will happen, but it may grow large enough that its contractual obligations with third parties require a cybersecurity framework, audit, software, etc. Otherwise, the company won’t get that business.

Which companies face the greatest threat?

Small and mid-sized businesses are the most at risk today, as the lowest-hanging fruit within the threat landscape. Surveys have found an estimated 80 percent of small and mid-sized businesses have been victimized by ransomware within the last 18 months, and only 20 percent of them reported it.

These companies typically don’t have an IT company with expertise in security mechanisms and controls managing their infrastructure. Owners of small and mid-sized businesses often don’t put the resources into a cybersecurity strategy because they don’t recognize the need — although this is starting to change as they’re targeted.

Within the small and mid-sized business sector, the most targeted are health care, which includes small doctors’ offices, and government organizations like schools.

Where do you recommend businesses start with risk mitigation?

You should put in security controls and a framework to protect your company. Bring in a trusted adviser to talk about the risks within the operation and how to protect important data. Consider putting in a customized cybersecurity strategy that makes sense — John’s Auto Body will have a very different approach than Bob’s Dental, which must follow certain regulations. 

It all starts with a business conversation and it’s critical to have that conversation before the bad actors get ahold of your information.

Insights Accounting is brought to you by Rea & Associates

Knowing your company’s advantages adds value when it’s time to sell

The drivers of a company enterprise value are a company’s strengths — internally, in how they operate, and externally, in the marketplace. They’re also of critical importance to buyers as they look for companies to acquire.

During due diligence, a company’s strengths and weaknesses will be scrutinized.

“Due diligence is run essentially to find out if what an owner says drives value in his or her company actually does,” says Steve Ford, director at Brady Ware Capital.

That’s why owners should clearly understand their company’s value drivers. Doing so helps them see their company through the eyes of an outsider, and that perspective can help them maximize the value of their company. However, this can only be done if they start preparing for a transaction well ahead of a planned sale.

Smart Business spoke with Ford about how a clear understanding of a company’s value drivers can help owners prepare their business for a sale.

How well do business owners understand the drivers of value in their company?

Business owners tend to know their value drivers instinctively by operating a business for years. However, when an owner meets with potential buyers, they must be able to articulate and communicate those value drivers clearly and succinctly. Most owners don’t get too many opportunities to take a step back and view the company through the eyes of an outsider. That can make those values drivers tricky to articulate.

Because buyers are basing much of their acquisition decision on a company’s unique value drivers, it’s important for business owners to present them clearly and define how they differentiate the company in the marketplace in which they operate.

How can business owners ensure they understand their company’s drivers of value?

Business owners can start by asking themselves questions about their business. For example, they could ask questions about the depth of the management team, the strength of their financial data, their customer concentration and more. By asking these types of questions, business owners can better identify their strengths and areas that need improvement — it’s better that owners discover they don’t have a strong answer than a buyer discovering an unaddressed weakness.

While not recognizing a weakness is an issue, understanding where the company could improve and addressing it with potential buyers is a good move that shows candor and a willingness to work together with a new owner/partner. Owners should articulate their position and be direct. But if a buyer has to inform an owner what’s wrong with their company, the owner has little chance of maximizing value.

When should business owners begin preparing their company for a sale?

It’s better that owners start the process when they want to, rather than when they have few other choices. Often owners really start thinking about an exit when they find themselves emotionally struggling, when there’s no one in the company to succeed into ownership, or when the industry dynamics change in such a way that the company would need to significantly alter its approach to stay competitive. When those signs arrive, it’s probably time to consider an alternative strategy. And that’s when owners should consult their trusted advisers about a path forward.

At a minimum, owners should start preparing their business for a sale two years ahead of a planned exit date. Lean on trusted service professionals to help address weaknesses and get the company sale-ready.

Business owners also need to prepare themselves to leave the business. They should take an honest assessment of why they feel they’re ready to exit. Look to see if there’s anything that can be done to get re-energized, such as bringing someone on to handle more of the day-to-day operations, or adding a partner to share some of the risk and find new avenues for growth. But, if all signs seem to suggest that there’s no more joy in operating the business, it’s clearly time for a change.

When the time comes for an exit, there’s a significant amount of work to be done to maximize its value. Fortunately, business owners don’t, and shouldn’t, do this in isolation. By engaging with their own internal team and their trusted service professionals, owners can make a successful transition into whatever comes next.

Insights Accounting is brought to you by Brady Ware & Company

How to get your business, and yourself, ready for a sale

For every business owner, there inevitably comes a point at which they can’t, or no longer want to, run their company anymore. Owners who early on start laying the groundwork for that transition put themselves in a position to maximize their company’s value and set themselves up for a fulfilling post-sale life. 

“The sooner you think about your exit, the more options you’ll have — for yourself and the business — when the time comes,” says Scott McRill, shareholder, Transaction Advisory Services, Clark Schaefer Hackett.

He says business owners who are prepared can pass the company on to family, move operational responsibilities to key employees, or sell the business to a third party or to employees. 

“But early planning is critical,” he says. “Business owners who don’t plan could find themselves in a situation where they need to sell but have limited options, which negatively affects the sale price.”

Smart Business spoke with McRill about what owners can do to prepare their business, and themselves, for a transition.

How far ahead of a transaction should preparations for a sale begin?

The typical time frame is at least two to three years before the planned sale date. That should give an owner enough runway to make the operational improvements necessary to maximize the business’s value. 

To prepare for the transaction, owners should get a third-party view of the business’s financial situation. Having an accounting firm involved with two to three years of audited or at least reviewed financial statements helps ensure the numbers are clean, reconciled and presented in accordance with GAAP ahead of the transaction process. 

Often overlooked during preparation is the state of the management team. Many buyers expect that a capable management team is in place to run the business post-sale and will also expect the owner to stay on for a short transition period. But if a capable team is not in place, the buyer may expect the owner to stay on board during a much longer transition period.

Who should business owners engage to help them sell their business?

Owners tend to underestimate the amount of time and attention that’s needed to complete a transaction. The process — from marketing to close — could take six months to a year. It’s often a job in itself. 

A business owner can lean on the team — accountant, attorney, investment banker or business broker — for much of the sale preparation. That’s important because if the company’s performance deteriorates during a sale, it can erode business value in a transaction.

Owners should also consider seeking the advice of a wealth adviser to ensure the proceeds the owner gets from the sale can be applied to accomplish whatever goals he or she has in life after business ownership. 

What mistakes do business owners tend to make once they decide they’re going to sell?

Owners need to consider the emotional side of the equation — they often don’t take enough time to evaluate whether they’re personally ready to sell their business. Owners need to think through what will occupy their time post transaction.

That can be difficult, as many entrepreneurs have devoted tremendous energy and time to their business and haven’t pursued a lot of outside interests. Then, the day after a sale, they have no idea what to do with themselves, which can lead to seller’s remorse. 

The ‘life-after’ plan is a living, breathing analysis of post-ownership life. It’s something that should be in the back of an owner’s mind during the earlier, high-growth stages of a company. It’s common to see owners formalize that plan a couple years ahead of a transaction, though planning four to five years ahead of a sale would be better. 

As part of this plan, owners need to consider the lifestyle they want to live post-ownership. From that, they can determine what cash flow will be needed, which will help determine how much they need to sell the business for vs. what they might want to sell the business for. This step is important to the negotiation process. Without it, owners can be disappointed in a valuation without realizing that it’s more than sufficient to achieve their objectives.

Insights Accounting is brought to you by Clark Schaefer Hackett

Planning strategies for your business and you

Now is the time to think about 2019 tax planning — before you find yourself in a year-end scramble.

“Business owners have a better sense of what kind of year they are having, and how that may impact their tax bill. They still have time to act,” says Jane Pfeifer, CPA, Shareholder at Clark Schaefer Hackett.

Smart Business spoke with Pfeifer about how taxpayers can plan ahead to fully utilize beneficial tax options.

How did the finalized Tax Cuts and Jobs Act (TCJA) regulations and most recent IRS notifications impact planning?

Under the TCJA, the Section 199A business income deduction was created, allowing taxpayers who own interests in pass-through entities to take a 20 percent deduction of qualified business income earned in a qualified trade or business. Taxpayers need to know where they fall under the clarified regulations. The deduction does not apply to attorneys, accountants, doctors or dentists, and certain other professional service providers whose income is above $350,000 for married filing joint taxpayers or $157,500 for those filing as single taxpayers.

The TCJA made changes to Section 163(j) regarding limitations on interest deductions, which can have a significant impact on a taxpayer’s 2019 tax bill. This is another area where regulations were delayed.

If a company’s gross receipts are above $25 million, deductions for interest expense are limited to 30 percent of taxable income from the business, before depreciation, amortization and interest expense. If an entity has a loss for the year, its interest deduction may be limited. Or, if a business is highly leveraged, it may not get that full deduction if gross receipts are above the limit. Also, the gross receipts of all related entities may need to be considered.

How can depreciation help business owners?

To reduce income taxes, a business owner may want to purchase and place new fixed assets in service by the end of the year. Under Section 179, entities can elect to expense up to $1 million of qualifying property, which includes HVAC equipment, fire protection or security systems. This break is phased out for qualifying purchases over $2.5 million. In addition, 100 percent bonus depreciation is still in play for 2019.

While these deductions do not apply to real estate purchases, a cost segregation study divides a building into components, where some might qualify for accelerated depreciation. For instance, special wiring or adaptations required to run equipment can be reclassified to a shorter depreciable life.

Many states, however, disallow the aggressive depreciation deductions that are available on a federal level.

What changed for individual returns?

The standard deduction increased. For 2019, it is $12,200 for individuals and $24,400 for joint filers. Therefore, taxpayers may want to take the standard deduction one year and itemize the next. This can be done by accelerating 2020 charitable donations into 2019. Individuals may be able to do the same thing with medical expenses if these expenses exceed the adjusted gross income threshold.

Many people under-withheld in 2018. While taxpayers should have addressed this early in 2019, there is still time to mitigate under-withholding.The IRS requires a minimum withholding of 22 percent for special compensation like restricted stock or bonuses. Depending on a person’s overall tax bracket, the minimum is often not enough. Looking at this now may avoid an unpleasant surprise in April 2020.

What else should taxpayers keep in mind?

Individuals need to understand their capital loss carryforwards and investment portfolio. Should taxpayers offload underperforming stocks to generate a loss at the end of 2019 and offset gains? Could sales that generate gains be offset by loss carryforwards?

Taxpayers also should consider maximizing retirement and health saving account (HSA) deferrals. Individuals 49 and younger can defer up to $19,000 in a 401(k) plan; 50 or over can contribute up to $25,000. HSA contributions max out at $7,000 for family plans or $3,500 for individual plans. Taxpayers who are 55 or older can contribute an extra $1,000. If medical expenses such as braces, glasses, hearing aids, etc., are on the horizon, funding an HSA is like getting a tax deduction by moving money from one pocket to the other.

Insights Accounting is brought to you by Clark Schaefer Hackett

Quality of earnings: a unique perspective on a business

In a market in which deal valuations have reached a high-water mark, many owners are exploring a possible sale of their business. Those who are ready to take the next step should first think about how their business will look to potential buyers through the lens of a quality of earnings report.

“A quality of earnings report is typically ordered after a letter of intent as part of the financial due diligence,” says Thomas G. Wolf, CPA, a senior manager at Brady Ware & Company. “It’s important in negotiating and structuring a deal as it determines what may or may not be sustainable in terms of revenue and profits.”

Smart Business spoke with Wolf about quality of earnings reports, how they differ from audited financial statements and how they can be used outside of deal negotiations.

What is a quality of earnings report, and how does it differ from audited financial statements?

A quality of earnings report typically comes about as part of a transaction that’s being negotiated and is ordered by the buyer, seller or someone interested in investing in the business. The report aims to identify financial performance factors that aren’t reflected in the business’s financial statements, whether those are internal statements or audited financial statements, to determine the company’s normalized performance and sustainability.

Audited financial statements look to determine if transactions happened in accordance with GAAP. In performing an audit, CPAs look backward at what has happened and how it was reported.

A quality of earnings report looks forward. It seeks to identify sustainable revenues — those that are repeatable — and eliminate anomalies — anything outside the control of the company, such as broad economic factors, that won’t have an ongoing impact on the company’s financial performance. These reports can assess whether revenues are part of a smart management decision, or the lucky swing of a market force.

How long might this report take to produce, and what information is needed to create it?

It takes 30 to 45 days to produce a quality of earnings report, and it’s based on any and all financial information that would typically be part of an audit, such as transaction history, financial statements, customer and vendor contracts, employment agreements, a market analysis and any other information that may be relevant to the business. But the assembly of a quality of earnings report is more fluid than an audit. To understand how a revenue stream works, the report’s creator will follow any important information to its source — if a business says it’s got great vendor contracts, then evidence of that should be provided.

Owners will want to purify their financial statements ahead of a quality of earnings report. That means getting rid of any personal assets or expenditures that are on the company’s books. That will give the parties an accurate snapshot of the business and its performance at the due diligence stage.

Who should companies work with to get a quality of earnings report?

Typically, CPA firms are used because quality of earnings reports have financial information as the starting point, then dive deeper. There are specialized firms that will put together these reports. Private equity firms might have internal experts who can produce these reports, but sometimes that can present a conflict of interest. CPA firms, on the other hand, are necessarily independent of a transaction, and that objectivity lends more weight to the report for both sides.

How can a quality of earnings report be used to improve a company and its internal processes?

Not every deal goes through. Things can fall apart for any number of reasons. If that happens, the owner has a window to use the report to find aspects of the business that could be tightened up. This could include market risks that could be mitigated, vendor contracts that could be improved, etc. Just as a buyer could take the report and find potential pitfalls, the seller can do the same, using the report to make the company better and more attractive to buyers.

Insights Accounting is brought to you by Brady Ware & Company

Growth is great, but only if you’re prepared

Businesses that are growing — whether it be in volume or in new ways like creating a new product or pursuing a new market — are in fact setting themselves up for failure if their systems do not keep up. If your business’s operating system — how work is done — is outdated, growth slows and internal frustration rises.  

“An unreliable system means a company’s sales team, rather than growing the business, spends its time apologizing to clients because the organization cannot deliver,” says Ray Attiyah, author of “Run Improve Grow” and chief innovation officer at Clark Schaefer Hackett. “It creates conflict and turnover because employees feel ineffective as they struggle to realize success.”

Smart Business spoke with Attiyah about a leadership system that prepares companies to achieve their future goals by creating a properly designed operating system to accommodate growth. 

When a company’s systems, processes and standards fail to deliver, what is the impact?

New or rapid growth frequently exerts pressure on existing systems, and the more a company grows, the more difficult it becomes for employees to reliably meet increased demands. 

As a reaction to poor performance, managers may blame the frontline team for failures. Their haphazard problem assessment leads to poorly prescribed solutions such as ‘hold people accountable.’ They fail to assess whether workers have the appropriate tools to effectively do their jobs. Rather than engaging the workforce to listen to the symptoms and methodically define root causes for the failures, assigning blame is often demoralizing and creates fear of repercussions.

Other times, senior leaders question whether middle managers have the right skill set to lead critical improvements. Focusing on individual performers rather than all contributing variables can lead to multiple negative outcomes, including management turnover, a lack of confidence to pursue growth and an inability to meet increased business demands, or unprofitable growth (because resources are used inefficiently). This cycle is very tough on an organization.  

What is Run Improve Grow?

When a company pursues new growth, including new products, services, customers or sectors, it requires an operating system capable of reliably executing. And that is where Run Improve Grow (RIG) can help. 

RIG is a leadership system that focuses on where your people are spending most of their time. Are your frontline leaders empowered to effectively run the daily operations of your business? (RUN) Are your managers working on process improvements (IMPROVE), and are your executives working on the future of the business (GROW)?

With RIG, you empower your frontline workforce — the people responsible for making the products or delivering services — to be effective problem solvers capable of eliminating chronic pinch points that create daily frustrations.

How does Run Improve Grow differ from Lean or other forms of Continuous Improvement?

Lean is a method of gaining efficiency through waste elimination. RIG gives you the framework to develop a robust new system, rather than making patchwork changes to an existing system. RIG sees the waste in the management activities — not just in the workflow. Your employees are given the tools and authority to take action, enabling them to achieve results quickly.

How can organizations empower frontline employees and unlock everyone’s potential?

Empowerment occurs when employees have the authority, systems, standards and tools to succeed. There is nothing you can’t do when you have the confidence and internal support to do your job with conviction.

By applying the fundamental rules of RIG, your frontline leaders will clearly understand their role and be empowered to run the daily operations of your business without inhibitions. RIG creates a fearless and engaging culture that improves employee retention, which in turn attracts new talent, making recruitment easier.

With your employees operating at peak performance, management and your executive team are empowered to focus on process improvement, growth and innovation.

Insights Accounting is brought to you by Clark Schaefer Hackett

How the new lease rules may affect your balance sheet

The Financial Accounting Standard Board’s (FASB’s) new lease accounting rules are having a significant impact.

Historically, U.S. accounting standards classified leases as operating or capital, but the criteria for differentiating between the two has not been consistently applied. This inconsistent application has made it difficult for end users to compare financial statements. Now, nearly all leases must be reported on the balance sheet as a liability and a corresponding asset or a right-of-use asset.

“This could impact more than just leases and will have ripple effects throughout organizations,” says Brad Eberhard, principal at Clark Schaefer Hackett. “For instance, people are looking at their service contracts to see if the contracts need to be considered under these new lease standards.”

“An IT service contract that identifies a server, for example, could fall under the new standard and need to be included on a balance sheet,” says Michael Borowitz, shareholder at Clark Schaefer Hackett.

Smart Business spoke with Eberhard and Borowitz about the changes to lease accounting and their impact on organizations.

Why was the change made?

The FASB sought to add consistency among reporting entities. It also moves U.S. accounting standards toward international standards, which adds increased uniformity.

End users felt financial statements were not always comparable and understandable, due to the subjective nature of applying the lease standards. The old lease standard essentially allowed companies to maintain a liability off the balance sheet, based on their interpretation of whether the lease was capital or operating. A company with a leased piece of equipment has received a service and has an obligation to pay, which is the definition of a liability. FASB concluded this as well and sought to move these ‘off balance sheet’ liabilities to the balance sheet.

When do companies need to be compliant?

Public companies have to comply with the new standard for periods beginning after Dec. 15, 2018, which impacts their current financial reporting. Private companies’ effective date starts with fiscal periods beginning after Dec. 15, 2019.

The 2018 filings of large public companies can guide private companies, but private companies should determine now how this new lease standard fits into their operations. The biggest implementation burden will fall on companies with a large number of leases, including larger retailers that lease locations, businesses with leased machinery and vehicles, or companies with significant service agreements. Businesses must evaluate each lease agreement to determine the lease value and record the value on the balance sheet. Additionally, all future leases will need to be evaluated. Even with these complexities, implementation is solvable.

Do you expect the lease standard to change how companies operate?

As leases are renegotiated, terms may be shorter. A 10-year lease might convert to a five-year lease with a five-year renewal option. That places a smaller liability on the books by calculating net present value based upon five years. However, the standards require the lessee to consider all renewal periods in the net present value calculations that are reasonably certain of exercise.

Also, there could be instances where rather than attaching service agreements to a specified piece of equipment, they will describe general equipment usage.

What else do employers need to know?

Software can assist with the complexities of leasing operations and the required calculations. Private employers, however, may not yet realize how deep this could go because they have not thoroughly reviewed all of their contract agreements yet.

With the help of their accountants, employers need to track down leases and service agreements and begin to understand whether they are being reported correctly. They should stay tuned as amendments and technical corrections are issued.

Companies need to start educating internal financial departments, as well as others who deal with contracts, like operations managers and sales representatives. As new leases are signed, business leaders should consider the effect on future financial reporting. Also, it’s important to determine how balance sheet changes will affect bank covenants as additional debt is added to the books.

Insights Accounting is brought to you by Clark Schaefer Hackett

Leases take a spot on the balance sheet with new accounting standards

Changes to the financial reporting of leases by the Financial Accounting Standards Board (FASB) is a decision that is more than 10 years in the making. The new standards require businesses to record all leasing arrangements on their balance sheets while also better aligning U.S. and international financial reporting standards. 

Public companies, some nonprofits and some employee benefit plans with annual periods beginning after Dec. 15, 2018, have already begun implementing the changes. All other calendar-year entities will need to adopt the new rules for annual periods beginning after Dec. 15, 2019. Doing so is not just a matter for accounting departments. These changes could potentially trigger loan covenants or otherwise make it necessary to revisit existing banking agreements, as the underlying basis for these financial relationships are likely to be impacted.  

Smart Business spoke with Eric J. Schnieber, a shareholder at Clark Schaefer Hackett, about the changes to the financial reporting of leases and what companies need to know about their impact.

What are the new standards and how do they differ from the previous standards? 

Under the old rules, capital leases, recognized as a form of term financing, hit balance sheets as both an asset and liability. Operating leases, which generally represented a stream of rent payments with no transfer of ownership, were only required to be disclosed in financial statement footnotes, a practice commonly referred to as off balance sheet financing. These inconsistencies created heartburn for many users of financial statements.  

Under the new standards, all leases will need to be recorded as a right-of-use asset with an offsetting liability on a company’s balance sheet. And that is a big change.

What will be the effect of these changes?

There is very real concern by some companies that these newly reported liabilities could have a significant impact on their financial statements (hundreds of thousands or even millions of dollars). Changes that significant will alter the complexion of a lot of balance sheets, which will impact the way banks and other financial institutions look at the debt profile and overall financial risk of a company. 

It is not all negative, though. The new standards are more consistent with those of foreign company financial disclosures. That could put U.S. companies seeking foreign direct investment in a better position to access new capital markets because foreign investors are more comfortable with the clarity the new standards offer. 

What should CEOs understand about the effect of these changes? 

CEOs should concern themselves with understanding what new liabilities will appear on their companies’ balance sheets. There is a chance that the changes could impact debt covenants, in which case a conversation will need to be had with the bank about amending those agreements so the company’s access to capital is not negatively affected.

There is also the chance that a company’s increase in liabilities could substantially affect its debt-to-equity ratio or fixed-charge coverage ratio, and that also may impact a company’s access to capital, or at least drive up the interest rate that is being applied. 

How can CEOs mitigate the impact the changes will have on their companies?

Companies that are reliant on leasing should prepare to talk with their banker(s) and other stakeholders by first having a conversation with their accountant. Accountants have significant knowledge on the topic and can help companies create a strategy before conversations with lenders are had. 

An accountant will help a company develop an analysis of its financial position given the standards changes and make clear the expected year-to-year effect the changes will have on the company’s balance sheet. From there, the company and its bank can discuss how those changes will affect the banking relationship and negotiate a plan. 

Time is running out, so start the implementation process now. Waiting until December 2019 could prove costly to companies from a financing perspective and would likely cause significant delays in financial reporting. 

Insights Accounting is brought to you by Clark Schaefer Hackett